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International Journal of Commerce and Management Studies (IJCAMS)

Vol.2, No.4, 2017

The Impact of Interest Rate and Exchange Rate Volatility on

Banks' Stock Returns and Volatility: Evidence from Pakistan

​Haider Ali, Muhammad Ahmad Shahid

prediction of economic growth. Economic growth can be


measured with many variables like industrial production,
gross domestic product and agriculture products etc. One
1. Introduction of the important variables of measuring the future
economic perspective is banking stock prices volatility
1. Introduction studied by Arnold, Borio, Ellis, & Moshirian (2012) who
Nature of economy affects the performance of concluded in the study banking industry volatility is a
financial sector of an economy as it plays important role strong indicator of future economic growth. They are of
for innovations. Developed countries needs less the view that there is strong and significant negative
innovations in the financial sector because they are already relationship between bank tock returns volatility and future
achieved the maximum growth in the innovation, whereas economic growth. So stability in stock prices is more
under- developed economies needs more versatility in important for economic growth. When there is stability in
innovative activities in services of financial sector. stock prices then it is associated with high economic
The extent to which innovation take place in the growth in future, whereas instability causes future
developing countries in the mobile banking. They reached decreased growth (Monnin and Jokipii 2010).
at the conclusion that 85 percent innovation take place in It is accepted globally that a sound developed and
only the developing countries in the mobile banking. The well organized financial system is worthwhile for the
main reason given by them is under developed countries circulation of economy of every country, especially for a
needs much innovation in the field of banking services as developing economy. Financial sector takes a special place
compare to developed countries (Boor, Oliveira, & in the performance of activities of development of sound
Veloso, 2014) economy. Levine (1997) says that those economies which
Economic stability also accounts for the have a sound and developed financial system prosper
performance of banking sector. Those countries where rapidly with regard to the stock market activities as
there are strict laws and orders outperform in banking compare to those which have weak and unstructured
services but where there is many economic evils like financial system.
corruption, do not perform well: this was seen in the study Different economists have different views for the
of ​(Park, 2012)​. He is of the view in his conclusion that importance of financial system for the economic
corruption affects significantly on the bank loan quality. development. According to Hicks (1969) and Bagehot
Corruption index and non-performing loans are positively (1873) the financial sector play very important role in
and significantly associated that destroys the performance boosting up the industrialization in England due to the
of banking sector and economic growth as well. In his facilitation of employment of capital for “immense work”.
study it was concluded that corruption disturb the (Ehnts, 1912) concludes that well performing banks
allocation of bank funds from profitable operations to bad outgrowth innovations in technologies by exploring the
projects. So a sound economy needs a well implementation opportunities and providing investments to those
of law and order in the country so that service sectors entrepreneurs with the best opportunities of employing the
specially banking sector can perform better. products and procedures. But some says financial system
To study the impact of exchange and interest rate and economic growth have no strong relationship (Levine
on the stock prices of banks is also important for future 1997).
International Journal of Commerce and Management Studies (IJCAMS)
Vol.2, No.4, 2017

Vibrant financial system is back bone to fill the under- developed economies needs more versatility in
gap of linking of weak and strong economic units. They innovative activities in services of financial sector.
are of the views that due to weaker financial system The extent to which innovation take place in the
developing countries face low economic growth. Moreover developing countries in the mobile banking. They reached
they also concluded that one of the reasons of low at the conclusion that 85 percent innovation take place in
economic growth may be due to low level of investment in only the developing countries in the mobile banking. The
productive opportunities (Roy, 2014). main reason given by them is under developed countries
The significance of stock market cannot be needs much innovation in the field of banking services as
forgotten while discussing the importance of financial compare to developed countries (Boor, Oliveira, &
sector for an economy. Stock market’s performance is Veloso, 2014)
connected with banking sector so it contributes in the Economic stability also accounts for the
economic growth of a country. (CHO & EUN, 1986) performance of banking sector. Those countries where
emphasized the importance of stock market for the there are strict laws and orders outperform in banking
economic growth. He believed that due to non-availability services but where there is many economic evils like
of stock market information, banking sector cannot work corruption, do not perform well: this was seen in the study
efficiently. Although interest rate ceiling and financial of ​(Park, 2012)​. He is of the view in his conclusion that
liberalization make banking sector efficient but it cannot corruption affects significantly on the bank loan quality.
outperform due to lack of stock market participation. Corruption index and non-performing loans are positively
Recently, the role of stock market is assessed on the and significantly associated that destroys the performance
economic growth in many studies. Almost in every study of banking sector and economic growth as well. In his
there was founded a positive and significant relationship study it was concluded that corruption disturb the
between economic growth and stock market performance. allocation of bank funds from profitable operations to bad
Technical efficiency level have increased in projects. So a sound economy needs a well implementation
banking sector of Pakistan and India over time, even of law and order in the country so that service sectors
Pakistani banking sector was experiencing slowdown in specially banking sector can perform better.
mids of 1990s but it is believed that changes in the To study the impact of exchange and interest rate
efficiency level will lead to significant regulatory reforms on the stock prices of banks is also important for future
in India, Pakistan and Bangladesh introduced in 1990s prediction of economic growth. Economic growth can be
(Jaffry et al.2007) measured with many variables like industrial production,
They are of the opinion that total factor gross domestic product and agriculture products etc. One
productivity in Pakistani banking sector increase over the of the important variables of measuring the future
period of time in the sample period. So it is concluded in economic perspective is banking stock prices volatility
this study that significant reforms can enhance technical studied by Arnold, Borio, Ellis, & Moshirian (2012) who
efficiency in the banking industry. It is agreed that sound concluded in the study banking industry volatility is a
and viable functioning of financial system can bring strong indicator of future economic growth. They are of
positive changes in economic development (Andersen & the view that there is strong and significant negative
Tarp, 2003) because increase in per capita income allow relationship between bank tock returns volatility and future
persons to increase their deposits and savings. economic growth. So stability in stock prices is more
State bank of Pakistan is mainly playing very important for economic growth. When there is stability in
important role for the development of financial sector. It stock prices then it is associated with high economic
serves for the development of country and all its listed growth in future, whereas instability causes future
banks also. The major source of funding for development decreased growth (Monnin and Jokipii 2010).
projects comes from the commercial, saving and Islamic It is accepted globally that a sound developed and
banks (Oguntuase & Omolade, 2013). So investors in well organized financial system is worthwhile for the
banking sector needs to know the stock return and their circulation of economy of every country, especially for a
volatility. developing economy. Financial sector takes a special place
Nature of economy affects the performance of in the performance of activities of development of sound
financial sector of an economy as it plays important role economy. Levine (1997) says that those economies which
for innovations. Developed countries needs less have a sound and developed financial system prosper
innovations in the financial sector because they are already rapidly with regard to the stock market activities as
achieved the maximum growth in the innovation, whereas
International Journal of Commerce and Management Studies (IJCAMS)
Vol.2, No.4, 2017

compare to those which have weak and unstructured State bank of Pakistan is mainly playing very
financial system. important role for the development of financial sector. It
Different economists have different views for the serves for the development of country and all its listed
importance of financial system for the economic banks also. The major source of funding for development
development. According to Hicks (1969) and Bagehot projects comes from the commercial, saving and Islamic
(1873) the financial sector play very important role in banks (Oguntuase & Omolade, 2013). So investors in
boosting up the industrialization in England due to the banking sector needs to know the stock return and their
facilitation of employment of capital for “immense work”. volatility.in the data
(Ehnts, 1912) concludes that well performing banks
outgrowth innovations in technologies by exploring the
1.1 Stationery of Foreign exchange rate at
opportunities and providing investments to those level
entrepreneurs with the best opportunities of employing the
products and procedures. But some says financial system Null Hypothesis: FX has a unit root
and economic growth have no strong relationship (Levine Exogenous: Constant
1997). Lag Length: 0 (Automatic based on SIC, MAXLAG=22)
Vibrant financial system is back bone to fill the
gap of linking of weak and strong economic units. They t-Statistic Prob.*
are of the views that due to weaker financial system
developing countries face low economic growth. Moreover Augmented Dickey-Fuller test
1.280805 0.9986
they also concluded that one of the reasons of low statistic
economic growth may be due to low level of investment in Test critical
1% level -3.43569
values:
productive opportunities (Roy, 2014).
5% level -2.86378
The significance of stock market cannot be
10%
forgotten while discussing the importance of financial -2.56802
level
sector for an economy. Stock market’s performance is
connected with banking sector so it contributes in the Our null hypothesis in the unit root test is that
economic growth of a country. (CHO & EUN, 1986) foreign exchange has a unit root but according to the
emphasized the importance of stock market for the figures the value of probability is 0.9986 that indicates that
economic growth. He believed that due to non-availability data has a problem of unit root, which should be cleared
of stock market information, banking sector cannot work first by using first level difference. If the problem of unit
efficiently. Although interest rate ceiling and financial root test still persists then second difference will be taken
liberalization make banking sector efficient but it cannot and so on.
outperform due to lack of stock market participation.
Recently, the role of stock market is assessed on the 1.2 Foreign exchange rate stationary at first
economic growth in many studies. Almost in every study difference
there was founded a positive and significant relationship
between economic growth and stock market performance.
Technical efficiency level have increased in Null Hypothesis: D(FX) has a unit root
banking sector of Pakistan and India over time, even Exogenous: Constant
Pakistani banking sector was experiencing slowdown in Lag Length: 4 (Automatic based on SIC,
mids of 1990s but it is believed that changes in the MAXLAG=22)
efficiency level will lead to significant regulatory reforms
in India, Pakistan and Bangladesh introduced in 1990s
(Jaffry et al.2007) t-Statistic Prob.*
They are of the opinion that total factor
productivity in Pakistani banking sector increase over the Augmented Dickey-Fuller test
period of time in the sample period. So it is concluded in -13.0624 0.0000
statistic
this study that significant reforms can enhance technical
efficiency in the banking industry. It is agreed that sound Test critical
1% level -3.43571
and viable functioning of financial system can bring values:
positive changes in economic development (Andersen &
5% level -2.8638
Tarp, 2003) because increase in per capita income allow
persons to increase their deposits and savings.
International Journal of Commerce and Management Studies (IJCAMS)
Vol.2, No.4, 2017

10% 10%
-2.56802 -2.56802
level level

After clearing the problem of unit root from the As discussed above that issue of unit root should
variable foreign exchange, now the data is clear to infer be solved first. At first level of unit root test this problem
some statistical technique. As it is shown in above table has been resolved now the data is available to infer some
that value of probability is 0.0000 which means that now statistical tool.the value of probability in the first level is
data do not have unit root and stationery problem. 0.0000 it means the data is free from unit root problem.
1.5 Stock return stationary at level
1.3 Interest Rate Stationary at Level
Null Hypothesis: ST has a unit root
Null Hypothesis: INT has a unit root Exogenous: Constant
Exogenous: Constant Lag Length: 0 (Automatic based on SIC,
Lag Length: 5 (Automatic based on SIC, MAXLAG=22) MAXLAG=22)

t-Statistic Prob.* Prob


t-Statistic
.*
Augmented Dickey-Fuller test
-2.37838 0.1481
statistic
Augmented Dickey-Fuller test 0.00
-36.772
1% statistic 00
Test critical values: -3.43571
level Test critical
1% level -3.43569
values:
5%
-2.8638 5% level -2.86378
level
10% 10% level -2.56802
-2.56802
level Same is the case with variable named as stock
According to null hypothesis interest rate has unit return. The unit root test has been applied at level. The
root. But after checking the variable interest rate the value value of probability is zero, which means that data do not
of probability is greater than zero which means this have stationery problem.
variable has problem of stationery which will cause the
problem in testing or in the inference of the data in a
model.so this problem of unit root test must be cleared 1.6 Stock Return stationery at first difference
first.
1.4 Interest rate stationery at first difference Null Hypothesis: ST has a unit root
Exogenous: Constant
Null Hypothesis: D(INT) has a unit root
Lag Length: 0 (Automatic based on SIC, MAXLAG=22)
Exogenous: Constant
Lag Length: 4 (Automatic based on SIC, MAXLAG=22)
Prob.
t-Statistic
*
t-Statistic Prob.*
Augmented Dickey-Fuller test 0.000
-36.772
statistic 0
Augmented Dickey-Fuller test
-22.6143 0.0000
statistic Test critical
1% level -3.43569
Test values:
critical 1% level -3.43571
values: 5% level -2.86378
5% level -2.8638 10% level -2.56802
International Journal of Commerce and Management Studies (IJCAMS)
Vol.2, No.4, 2017

As null hypothesis is that banking sector stock return has


no ARCH effect which means that there is no
Just to equate the variable stock return index with hetroskidestisity. But the value of f-statistics is 0.0000
interest rate and foreign exchange rate for resolving the which rejects null hypothesis and accepts alternate
problem of stationerity the unit root test is applied at first hypothesis when there is arch effect in the data then the
difference. Although the unit root test was clear at level. best suited model for statistics is M. GARCH
But just for equality purpose it was applied at first
difference.
1.9 Autocorrelation of ST
1.7 ARCH test of Foreign exchange rate
Null hypothesis FX has no ARCH effect

ARCH Test:

F-statistic 602906.2 Probability 0

Obs*R-squared 1175.707 Probability 0

As null hypothesis is that foreign exchange rate


has no arch effect which means that there is no
hetroskidestisity. But the value of f-statistics is 0.0000
which rejects null hypothesis and accepts alternate
hypothesis when there is arch effect in the data then the
best suited model for statistics is GARCH-M.
ARCH test of INT

ARCH Test:
A test is applied to check the autocorrelation in the data.
F-statistic 2719.472 Probability 0 The values are clearly showing that there is autocorrelation
in the variable stock return of banking sector of the model
Obs*R-squared 822.3748 Probability 0 so in this situation a model named M GARCH is applied
which covers problem of autocorrelation and
hetroskidestisity.
As null hypothesis is that interest rate has no
ARCH effect which means that there is no
hetroskidestisity. But the value of f-statistics is 0.0000
which rejects null hypothesis and accepts alternate
hypothesis when there is arch effect in the data then the
best suited model for statistics is -M.GARCH

1.8 ARCH test of ST


ARCH Test:
193.837
F-statistic Probability 0
7
166.691
Obs*R-squared Probability 0
8
International Journal of Commerce and Management Studies (IJCAMS)
Vol.2, No.4, 2017

which covers problem of autocorrelation and


1.10 Autocorrelation of FX hetroskidestisity.

1.12 Result of GARCH

Variance Equation
C 79.154 4.657402 16.99531 0
RESI
D 0.621215 0.041916 14.82061 0
(-1)^2
GARC
0.437628 0.021804 20.07142 0
H(-1)
D(INT) 36.96201 19.64147 1.881835 0.0399
D(FX) -153.4114 33.20045 -4.620763 0

The above results indicate that volatility of bank


stock returns are significantly affected by its own past
volatility as the value of ARCH term is 0.6215(0.0000).
GARCH term of the model is also significant which show
A test is applied to check the autocorrelation in that volatility if bank stock returns is persistence.
the data. The values are clearly showing that there is Volatility of both interest rate and foreign exchange rate
autocorrelation in the variable foreign exchange of the have significant effect on the volatility of bank stock
model so in this situation a model named M-GARCH is returns.
applied which covers problem of autocorrelation and 1.13 GRAPH of FX
hetroskidestisity.
1.11 Autocorrelation of INT

A test is applied to check the autocorrelation in


the data. The values are clearly showing that there is
autocorrelation in the variable interest rate of the model so The graph showing the volatility of foreign
in this situation a model named M-GARCH is applied exchange rate form the period 2009 to 2013.These rates of
International Journal of Commerce and Management Studies (IJCAMS)
Vol.2, No.4, 2017

foreign exchange rate is on daily basis. The picture is clear There is high volatility in the initial time of
that foreign exchange rates has increasing trend. There are sample period and at the ending time of sample period. But
so many fluctuations but trend of increasing has been fluctuations persisted in the whole sample period.
observed in the sample period.
2. Conclusions and Recommendations
1.14 GRAPH of INT The profitability of financial sector is of utmost
important for policy makers and investors of home country
as well as foreign country. The purpose of the study was to
examine the impact of interest and exchange rate volatility
of stock return of banking sector. For the purpose of
accomplishment three variables were used. Interest rate,
exchange rate is independent variables and third variable is
the stock return of all listed banks of Karachi stock
exchange. As the banking sector profitability is concerned
with number of stakeholders mentioned in the
introduction. The volatility of banking sector return affects
the decisions of investors, hedgers, policy makers etc. So
this study will help all those stakeholders who concerned
with the fluctuations of profitability of financial sectors
and volatility of exchange rates and interest rates.
M-GARCH models was used to examine the impact of
independent variables on stock returns of banks. The data
analysis exposes that interest and foreign exchange rates
The volatility in the interest rate is high. As seen
are significantly affecting the stock returns of all the
in the graph these fluctuations are high and this impact on
banks. So the concerned policy makers, hedgers, investors
the stock return of financial sector.
of home country and foreign investors should take into
considerations the results of the study. Hedgers can
1.15 GRAPH of ST consider this study while hedging their portfolio of
investment with the exchange rate fluctuations which is
found to be significantly affecting the stock returns of
bank. The findings are supporting the portfolio theory as
referred in the theoretical framework. The decision making
authority of exchange rate and KIBOR can improve their
decisions as both these variables are sensitive towards
return of banking sector. one of the economic indicator
which contributes to GDP is financial sector. So policy
makers in monetary policy have to be conscious about the
volatility of both the KIBOR and exchange rates.
The authorities of stock market should also be
vigilant towards volatility of both the independent
variables. As for as the limitations of the study is
concerned, at individual level of each bank, the impact of
both these variables could be observed. So that an
individual bank can make better control within the
organization. For better control feed forward control
concept can help banking sector to upgrade their
performances at individual level as well as at aggregate
level.
International Journal of Commerce and Management Studies (IJCAMS)
Vol.2, No.4, 2017

of innovation and diffusion in mobile banking services.

Econ Papers , 1594-1607.


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